Economists are legendary in their theoretical and philosophical differences. The extent to which the government should stimulate the economy is hotly debated, as are the causes of inflation. Regardless of the different perspectives, there can be no debate that expansionary fiscal policies can be inflationary. The implications for businesses are serious.

Background

The Employment Act of 1946 committed the federal government to enact policies that would promote full employment. The act was passed at the end of World War II amidst fears that the economy would slide back into the depression that has existed before the war. With the pent-up demand from the war years, the economy boomed and the government began to exert its weight to stimulate the economy more. The fiscal policies that have been implemented based on this mandate include the taxing and spending policies that the government pursues.

Expansionary Fiscal Policies

The business cycle brings periods of robust growth and economic expansion, followed by recessions during which the economy contracts. The role of the government is to cool the economy during the expansions and stimulate it during the contractions. Theoretically, the government could run a surplus during the expansion by restraining spending, while tax revenues rise due to more people working and paying more taxes. In the recession, this surplus could be used to meet the increased demand for government services while tax collections decline. In reality, the government’s policies have been consistently expansionary, with the result being that government spending consistently outruns tax collections. By the end of 2012 the national debt had surpassed $16 trillion and was growing at more than $2.5 billion per day

Two Kinds of Inflation

Economists distinguish between Demand-Pull inflation and Cost-Push inflation. When the economy is performing at capacity, excessive demand for goods and services pulls up prices – it is a supply and demand application. The cost-push theory focuses on the production side. As suppliers produce more goods to meet demand, their demand for resources including labor increases, driving up the cost of production and the prices of the goods they produce. Regardless of which approach you take, excessively expansionary fiscal policy creates the excessively strong demand. Inflation distorts decision-making, hurting creditors who are repaid in devalued dollars and makes it difficult for business owners to plan for the future.

The Monetarist View

The late Milton Friedman, Nobel laureate economist with the University of Chicago, summed up the monetarist view of inflation by stating that inflation is always a monetary phenomenon. When the federal government pursues an expansionary fiscal policy it historically does so with deficit spending. To cover that negative balance, the government borrows money. When the Federal Reserve System purchases some of that debt, it does so with newly-created money – creating money is one of the Fed's roles. Again, the laws of supply and demand apply. When the money supply is expanded, the value of the dollar drops and prices rise. China and other foreign governments have absorbed much of our deficits, but there is no guarantee that they will in the future. The inflationary bias of expansionary policies is a concern that all businesses should heed. With debt service taking a larger share of the federal budget, the cost may explode when interest rates inevitably rise.

References

About the Author

Thomas Metcalf has worked as an economist, stockbroker and technology salesman. A writer since 1997, he has written a monthly column for "Life Association News," authored several books and contributed to national publications such as the History Channel's "HISTORY Magazine." Metcalf holds a master's degree in economics from Tufts University.